November 24, 2009

Interest rates at center stage

"The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end."

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. A bit more precisely, the levels of real interest rates are tied to the growth rate of the economy. When growth is slow, rates are low.

The intuition behind this point really is pretty simple. When the economy is struggling along—when consumer spending is muted and businesses' taste for acquiring investment goods is restrained—the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. However, the net percentages of banks that tightened standards and terms for most loan categories continued to decline from the peaks reached late last year."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

"The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

"Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

"Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:

But the quantity of bank lending is decidedly not on the rise:

There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

By David Altig, senior vice president and research director at the Atlanta Fed

or IMPOUNDING savings within the commercial banking system, both are contractionary (the source of savings deposits within the monetary system is other bank deposits, directly or indirectly via currency, or the bank's undivided profits accounts).

Lower the remuneration rate on excess reserves. Then get the member banks out of the savings business. I.e., money flowing “to” the intermediaries never leaves the monetary system as anyone who has applied double-entry bookkeeping on a national scale should know. And why should the member banks pay for something they already own (interest). The member banks would be smaller, and more profitable, if they did not (1966 proved that, Dr. Alton Gilbert wasn't an expert: "Requiem for Regulation Q: What It Did and Why It Passed Away").

Monetary savings are LOST TO INVESTMENT (bottled up), within the banking and monetary system. I.e., savings held within the monetary system have a transactions velocity of zero, and are a leakage in the Keynesian national income concept of savings.

IOR's are not offsetting when the system's expansion coefficient varies widely

On IORs: Banks create new loans-deposits. The bankers are getting paid twice, for new, free, and additional earning assets (regardless of the expansion coefficient). Interest on reserves is a fraud and deceit upon the American people.

Thanks for doing this blog. I'll try to keep my comments to a technical nature.

On one hand, I agree that there has been some flight to safety in recent weeks, which I think reflects concerns about the economy's dependence on monetary stimulus, and the sustainability of the stimulus.

On the other hand, I also see indications that the recent retreat in Treasury rates is due also to an increase in the scale of monetary stimulus. The federal funds rate has fallen in recent weeks to around 12 bips, after hovering around 20 bips for most of the year.

This decline roughly coincided with the recent redemption of $185 billion from Treasury's supplementary financing account, which boosted the pace of the increase in excess reserves.

Also, for most of this year the Fed had been able to restrain the stimulus effect of its asset purchase programs by reducing borrowing from the Fed - in essence, replacing the large borrowed reserves built up in 2008 with non-borrowed reserves. But there seems to be little borrowed reserves left that the Fed can reduce, and so its asset purchases seem recently to be translated practically 1:1 into additional excess reserves.

Or this could perhaps be a case of steady monetary stimulus having partly delayed, and thus accelerating effects.

In a different time in a different country, a central banker once explained to me how he would know when monetary stimulus had surpassed its usefulness. He said it's like trying to pour coffee while blindfolded: the only way you know the cup is full is when you can feel the coffee spilling across the table. By that he meant when CPI accelerates.

But this is a novel situation, in which the scale of monetary stimulus is very large and yet the deflationary forces from deleveraging are very powerful. So perhaps the coffee is spilling out, but the table is tilted enough that the Fed isn't feeling any where it has its hand.

The Fed is in a box. Raising short term rates now would be bad policy. Perhaps being more stringent on the type of collateral that they take would be a step toward signaling to the market that they are ever vigilant, and are not encouraging bubbles.

Saving is up because people are scared (in the US). Bankers have told me they cannot find good credit risks to lend to. Plus, their existing loans are being paid off as quickly as possible. They are forced to buy treasuries to put their money to work.

The propensity to save in Asia is high. There seems to be a cultural bias toward saving versus spending. The Chinese populace has become richer, but they have not spent those riches and are saving them.

It would be interesting to look at the savings rate of the US from the late 1880's to 1920 to see how it compares. Maybe there is a correlation with saving and development?

Secondly, the economic environment is so uncertain. Business is terrified of the coming actions of the Obama administration. Cap and trade, higher taxes, health care regulations and taxes, pro union actions, and more regulation in general are troubling to any business. The costs of all these actions are not easily quantified into any model-so it's hard to make a decision. The result, is no action. Cash piles up.

In regard to the final question, why is the demand to borrow seemingly lower than the supply of capital, I wonder if it is some combination of:

A. Demographic changes - if young people generally borrow and take risks, and older people generally save (lend), perhaps the baby boom retirement is causing too much savings to chase too few risk takers?

B. Business changes - in the past, the hottest areas of the economy (say railroads) required large amounts of capital investment. Increasingly, the hottest areas (the internet/google) use relatively little capital, and are largely self-financing. Perhaps this shift implies that the same amount of savings is now chasing fewer opportunities for capital investment.

C. Changes in retirement expectations - in the early 1900s, I think many people never expected to retire, and consequently never saved. Now, most expect to retire and most save to attempt to fund that retirement. That increases the number of people looking to save/lend.

I wonder if A, B and C are large enough to cause macroeconomic impacts. I think they could amplify each other, in the sense that there are both fewer risk-taking borrowers per retiree/lender, and each risk-taker needs less capital investment than before.

I'd like to play devils' advocate with regard to the fear of rampant inflation that is expected.

True, the money supply has expanded enormously in the credit crisis. It is mind boggling to think about. How could it not lead to rampant inflation?

First, the money isn't in the economy. It is on bank balance sheets.
They are reinvesting it in government treasuries. They are not lending it. As a matter of fact, their credit standards are so high they won't lend it. Furthermore, their outstanding loans are being repaid-so this cash is being reinvested in treasuries as well.

Once the Fed sees that money is being lent out-and the velocity of money picks up-they undertake open market operations aggressively to sop up cash. They raise discount rates by a little-and change the collateral that they take to make it tougher for prime brokers to get cash from the Fed.

If they are fast enough, we will have limited inflation in the overall economy.

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November 20, 2009

Housing back in the news

Housing back in the news

Two reports released this week remind us of the difficulties still confronting the residential real estate market. First, the consumer price index (CPI) showed continued moderation. Yes, the overall number was up 3.4 percent on a monthly annualized basis, and even the core measure ticked up 2.2 percent. But over half of the core rise was related to rising new and used car prices following the expiration of the cash-for-clunkers program. The Cleveland Fed's median CPI, which isn't influenced by these outliers, was up only 1.2 percent and still suggestive of some considerable disinflationary pressure.

What does the CPI have to do with housing? Well, the shelter component of the index, which is derived largely from rents, was unchanged and has risen only 0.7 percent over the past year (see chart below). This performance represents unprecedented lows for this, the largest of the major CPI categories, and is a good indication of the downward price pressures being felt in the residential housing market.

More directly related to the state of housing was Tuesday's report on new home starts, which dropped sharply. Starts fell 10.6 percent in October, a surprising decline for a series that appeared to bottom out in April and stabilize in recent months. But perhaps a few bumps along the road to recovery are to be expected.

In recent months it appears that home prices as measured by the S&P/Case-Shiller Index have stabilized and begun to improve while home sales have picked up notably and listing inventories of new and existing homes have fallen. However, these listing inventories fail to capture a large share of the market including homes for sale by owner, potential buyers on the sideline waiting to see improvement, and foreclosure properties that have not yet made it to market but likely will eventually.

RealtyTrac reported that foreclosure activity slowed for the third straight month in October, down 3 percent from the previous month. However, those receiving notices of defaults increased 2 percent after declining 12 percent the prior month. Bottom line, foreclosure filings remain at high levels.

Amherst Securities released a report in September that took a stab at calculating the current shadow inventory of foreclosure properties using the Truilia listing database. In light of increased sales and slowing foreclosure filings, let's see how things are going:

Comparing the September report and the November numbers, we see that listing inventories declined 3 percent, which is to be expected with the pick-up in existing home sales numbers that the National Association of Realtors has been reporting in recent months. However, the shadow inventory of foreclosed homes grew by 9 percent (real estate owned, or REO, properties grew by 4 percent), helping to drive total inventory up 2 percent from September to November.

Homebuilding was a driving force in the economy in the years leading into the recession. Looking forward, though, the homebuilding industry is continuing to face significant obstacles, including inventory challenges. Those challenges translate into homebuilders being understandably wary to move ahead on new construction until foreclosures and REO inventories measurably subside. Thus, the homebuilding challenge continues.

By Whitney Mancuso, senior economic research analyst, and Mike Bryan, vice president, both in the Atlanta Fed's research department

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November 12, 2009

Small businesses, small banks, big problems?

In a speech on Tuesday, Federal Reserve Bank of Atlanta President Dennis Lockhart drew some connections between the current commercial real estate (CRE) problems and the prospects for a small business-led recovery.

The starting point was an observation made in an earlier macroblog post that identified the important role small businesses have traditionally played in job creation in the economy and how they had been disproportionately negatively affected in this recession.

What are the connections between CRE and small business? An obvious direct link running from small businesses to CRE is that small businesses are an important source of demand for many types of commercial space. A link from CRE to small businesses is that CRE problems in banks could potentially affect credit availability for small businesses.

CRE pressures
The problems currently facing the CRE industry have been building for some time for both property owners and the holders of CRE debt:

The income generated by nonresidential/nonowner-occupied CRE has generally been falling as vacancy rates on commercial space rose, and capitalization rates–the ratio of income to valuation–have climbed sharply.

The decline in CRE valuations has created a significant amount of "rollover risk" when CRE loans and mortgages mature and need to be refinanced (about $340 billion in CRE debt is estimated to mature in 2010 and 2011). At the same time, delinquency rates on CRE loans have been increasing sharply, especially for CRE lending for residential construction and development purposes.

Small business lending
Banks have already responded to the generally weakened economic conditions and reduced creditworthiness of borrowers by raising credit standards for all types of lending, including commercial loans, credit cards, and home equity. But there is a risk that additional bank problems, such as the realization of substantial CRE losses, could further constrain bank lending right at the time when credit is needed to support economic growth.

President Lockhart draws the connection between further bank problems and the prospects for small business-led recovery by observing that small businesses depend significantly on the banking sector as a source of financing. (A 2003 Federal Reserve survey of financial services used by small business showed over 50 percent of small businesses had a credit line or bank loan. In addition about half of small businesses use a personal or business credit card.)

The dependence of small businesses on banks is particularly problematic if the banks facing the most severe CRE problems also are a significant source of loans to small businesses.

It turns out that much of the CRE exposure is concentrated among the set of 6,880 or so smaller banking institutions (banks with total assets under $10 billion). Based on the June 2009 Bank Call Report data, these banks represented 20 percent of total commercial bank assets in the United States but hold almost half of the CRE loans.

It seems reasonable to assume that the banks with high exposure to CRE (say, those with CRE exposure as measured by a CRE loan book that is more than three times their tier one capital) are likely to take a conservative approach toward additional loan growth. The bad news is that the banks with the highest CRE exposure also account for about 40 percent of all commercial loans under $1 million–the types of loans most likely used by small businesses.

It is important to recognize that this analysis does not automatically imply small businesses will not be able to get needed funding when demand increases. For instance, even if banks with high CRE exposure are unable to expand lending as demand increases, it is possible that other banks that are less constrained will be able to step in to provide the needed financing. Also, small businesses depend a lot on other sources of financing, such as credit cards, and the large card issuers tend to have low CRE exposure.

Interesting that you identify the number one problem as poor sales.
Mega corporations reported earnings this week, top line revenue growth was poor. Earnings increased via cuts in expenditures.

Expectations going forward will be the driver of growth. Consumers today value cash over anything else. They know taxes are going up in 2010, and they also intuitively know that when government gets aggressive in regulatory matters, it gets expensive to do business.

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November 06, 2009

What is systemic risk, anyway?

On October 30, the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta held a conference on Regulating Systemic Risk. The presentations mostly focused on the recent financial crisis and possible regulatory responses to those developments.

Oddly enough, the term systemic risk hardly came up even though it was a major part of the conference's title. Then again, maybe it wasn't so odd.

Systemic risk is a relatively new term that has its origin in policy discussions, not the professional economics and finance literature. A search of EconLit turned up the following: The first appearance of the term systemic risk in the title of a paper in professional economics and finance literature was in 1994. That appearance was in a review of a book written by a World Bank economist, not a journal article by an economist at a university.

Given its origin in policy discussions, perhaps it is not so surprising that the term "systemic risk" often is used with no apparent precise definition in mind. If it arose from a theoretical analysis as did a term it sometimes is confused with—systematic risk— there would be a very precise definition.1

"Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."

While this is a reasonable definition in terms of the concerns in mind, the precise definitions and measurement of terms such as "confidence," "uncertainty," and "quite probably" are likely to be elusive for some time, if not forever. Furthermore, the definitions probably include a lot more than what usually seems to be meant by systemic risk. For example, the risks of an earthquake, a large oil price increase, and a coup fit in this definition. Or maybe "systemic risk" should include such events?

"Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."

To me, this definition is better than the G-10 definition because it does not confuse the event being analyzed (the breakdown) with the cause (the loss of confidence). Even so, a precise definition of "breakdown" may be elusive even if the term is evocative.

Darryll Hendricks (2009), who is a practitioner, suggests a more theoretical definition from the sciences in which the term originated:

"A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."

This definition includes many words that aren't used in everyday English and is quite abstract, focusing on the mathematics to characterize the situation. That said, this definition has a better shot at being more precise in terms of economic and financial analysis of actual situations than does the G10's definition. But the economic content of this definition as it stands is zero.

One solution is the following: Kaufman and Scott's definition is a reasonably clear, tentative definition of the term that doesn't use too many other words that require definition. Hendricks's more theoretical definition or something like it probably is a helpful start to ways of thinking about systemic risk in analytical terms.

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Hendricks definition suffers from a problem that the concept of equilibrium tends to be stationary, but we usually talk about systemic risk as building up. For example, the run up in housing prices or the worsening of global imbalances can be viewed as dynamic triggers of systemic risk events. Perhaps such phenomena could be represented in an equilibrium model that transitions to systemic risk, but maybe not.

It seems that it is necessary to distinguish endogenous systemic risk, i.e., that generated by the system itself that can lead to widespread market failure, such as excess leverage, from exogenous shock, since each requires a different approach.

Systemic risk occurs when economic actors are allowed to make promises that they don't have the wherewithal to keep.

Examples:

Banks promise that you can have your money back anytime you want even though they have lent it all out.

Banks promise that you can't lose money in your account even though there's a risk that the loans they have made will not be paid back.

AIG promised to make good on bond losses (CDS) even though they did not have the assets to cover the potential losses.

Annuity sellers promise fixed payments into the future even though they have no control over the rate of return.

Defined Benefit Pension plans promise future payments that they don't have the assets to cover.

The crisis comes when these promises are revealed to be empty promises. If you want a financial system without systemic risk the solution is simple. Don't allow anyone to make promises they can't keep.

I don't believe in systemic risk. I think that there is transaction risk-and not priced in or accounted for correctly in models.

What are the chances that your counter party won't perform? I am sure there were folks in the Investment banking industry that said there was no way Lehman would fall. They did.

The question should be how do we mitigate counter party risk? Then when dominoes start to fall, it doesn't take down more dominoes that cause intense losses throughout the whole system.

In 2008, I don't think there was enough cash put up throughout the entire system to hold positions. Of course, because of the amount of leverage in the market, that is an easy statement to make. But even today, I think risk is underpriced in the market.

The way I see you have a core and then bells and whistles. If something affects the core materially, then this is systemic. If something affects the bells it isn't, unless a bell that breaks necessarily also breaks a core.

So, then it's a matter of whats considered to be 'core'. Don't ask me, cause I don't know. Seems like land, and gold, and guns would probably involved.

I like Mr. Hendricks idea, but I wonder if the ladder can be busted down, can we also skip ahead? That is to say maybe we could learn to bust up to higher equilibriums more rapidly.

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